Monday, November 14, 2011
What can you learn about fracking from seeing the recent film Margin Call? Quite a bit actually. In the film, analysts at a New York investment house discover that they are holding large quantities of increasingly worthless mortgage backed securities. The drama involves their attempts to figure out what to do about it.
Serious questions have also been raised about the value of thousands of leases that have been generated over the last few years by the natural gas industry. Keep in mind that fracking is very capital intensive, much more so than conventional gas drilling. All the trucks that tear up local roads. All the chemicals. All the pipes. All the drilling rigs. It costs a lot of money to carry out that level economic and environmental destruction.
While the industry estimates that fracking is profitable when gas sells at 5 dollars per thousand cubic feet, independent analysts put the figure at 7. Natural gas wellhead prices peaked in 2008 at 7.97 dollars per thousand cubic feet. As result of the recession and mild winters, the price fell to 3.67 dollars per thousand cubic feet in 2009, recovering modestly to 4.16 dollars in 2010.
In general, we expect business activity to decrease when prices fall, but that hasn't been the case with natural gas fracking. This fact is largely attributable a change in SEC rules that allows producers to put undeveloped reserves on their balance sheets. As a result, companies can maintain share value while not actually pumping and selling the gas.
You might argue that it’s just a matter of time before gas prices increase and the drilled wells become profitable, but this is highly doubtful. The gas companies, it turns out, have vastly overestimated the amount of natural gas that can be tapped from shale gas generally, and the Marcellus shale in particular.
A U.S. Geological Survey Report released last summer cut by 80% the estimate of available gas in Marcellus deposits. And there is considerable other evidence that drilled wells are not producing at near the promised capacity. A New York Times report on this drew a massive defensive response from the industry.
This explains why the companies are so determined to expand their reach into New York and Ohio. Quite simply: they have to. They need to expand operations to keep inflating share price values and to secure loans to continue expansion. If they stop, and have to maintain profitability by pumping and selling gas, at the same time revealing what their assets are actually worth, they risk collapse.
Morning Star, with regard to Chesapeak Energy Corp, notes that there are “ongoing questions about the sustainability of the firm's business model, given its propensity to outspend available cash flow.” Still, it gives the company a “bullish” rating, due its “knack for creatively financing its operations and the relevance (that is, the attractiveness to third-party investors) of its current leasehold positions.”
Translation: "Chesapeak is good at cooking its books, and may be able to unload this crap before investors figure out that it’s a scam.”
If you’ve seen Margin Call, that should sound eerily familiar.
Leases tied to natural gas fracking are essentially like mortgage backed securities. At some point, they will be proven to have much less value than originally promised. And when that happens, shareholders, and--more importantly--those of us who live in the Marcellus Shale region, will be left holding the proverbial bag.